Urban Returns

This is what I mean by irrational

A bubble exists when people are paying prices that make no sense.  "No sense" as in, "There's no way in hell that this asset will ever generate enough income to pay them back."

Here's a nice illustration. 

The authors of this paper conducted an experiment with college students.  They gave each student some money and some "stock."  Trading was divided into 10 periods.  During each period, students were allowed to trade stock.  At the end of each period, each share of stock earned a divident of 20 cents with a 50% probability or 0 cents with a 50% probability.

The expected value of each share of stock was $1 before the first period (10 periods with an expected value of 10 cents after each period).  At the end of the second period, each share had an expected value of exactly 90 cents.  And so on.  At the end of the 9th period, each share had an expected value of 10 cents.

The students were told before the experiment how to value the shares of stock. But once trading began, the students quickly bid the price of shares well above their expected value.

This was not simply an instance of risk-preferring behavior, as the chart below shows.  Beginning with period 7, the average share price exceeded the maximumpossible total return.  Students paid an average of $1/share during period 7 even though the maximum return -- assuming a share hit the 20-cent dividend four times in a row -- was only 80 cents.  During period 10, shares traded at 90 cents even though the most each share could earn was 20 cents. 

This was not a freak event.  Nine out of ten experiments produced similar results.

If people can react this irratonally in a controlled experiment with clearly defined financial returns, the bubbles in the housing and credit markets are easy to understand.  We should probably be asking ourselves why we don't see more bubbles.

A modest proposal

In this time of economic turmoil, we need to think hard about how we can use federal tax policy to revive our lifeless economy.  We need bold ideas and bold leadership. 

I have a modest proposal:  Let's exempt from all stock dividends from taxation.  We would no longer treat dividends as ordinary income or any other type of income -- the government wouldn't take one thin dime of this investment income.

But let's not stop there:  let's also exempt all capital gains realized from the sale of stocks.

This policy would have three salutary effects.  First, it would induce a flood of money into the stock market.  We all know the stock market badly needs an infusion of cash right now.  And what's good for the stock market is good for the country.

Second, by encouraging taxpayers to invest in the market, we would simply be incentivizing them to do what's in their own best interest anyway.  We all know that investing in the stock market is a nearly sure-fire way of building wealth over the long-term, the current market blip notwithstanding.

Third -- and this is a more nebulous benefit, I admit -- taxpayers who own shares of stock make better citizens.  They care more about our government's economic policies and the quality of elected officials.  And they have an incentive to get more involved in civic affairs.  My proposal, simply stated, would make us all better citizens, or at least those who could afford some stock.

I really can't imagine a tax policy that would do more to strengthen our economy and civic spirit.

Sure, it might not be completely equitable.  The subsidy would benefit most those who have the most.  There's no way around the fact that someone earning $1 million a year in ordinary dividends would benefit more than someone earning just $100 a year.  Those who couldn't afford any stock at all, of course, would lose out completely, but remember, this is for the good of the country.

I also recognize that exempting dividends and capital gains would cause investors to bid up the price of stocks; the main beneficiaries would be those who already own gobs of stock on the date the subsidy took effect -- you know, the filthy rich.

But it's worth it to encourage badly needed investment in the stock market and make us better citizens.  And, remember, we'd be helping ordinary taxpayers by incentivizing them to do what's in their own long-term interest.

I believe this is a perfectly sensibe and defensible proposal.  After all, we already do it with homes.  

P.S. I thought my sarcasm was obvious, but judging from the comments, it apparently was not.  

Most people would say that these "justifications" are silly reasons to exempt dividend income and capital gains from taxation.  But these are the same justifications usually offered for exempting the imputed income from owning a home and the capital gains realized from their sale.

Bubbles in inelastic markets

I think one of the points I'm trying to make about bubbles is getting lost in all the back and forth:

Bubbles are fundamentally irrational events.

Now, even slight shifts in demand in an inelastic housing market will cause home prices to rise.  They're supposed to rise; that's a simple matter of supply and demand, first-day economics stuff.   But a sharp rise in prices does not a bubble make. Bubbles occur when an asset's price rises above its fundamental value.  In an inelastic market like LA, this means:  Prices first rise because of a shift in demand -- basic economics -- but then take off from there as the mass delirium that causes a bubble takes hold.

I don't think the sharp price increases in central LA, San Diego and DC could be justified by any rational valuation of homes as capital, income-producing assets -- although they certainly could have triggered frenzied investment by new investors. I instead claim they were bubble prices and therefore had to crash. This crash had to happen regardless of the strictness of land-use regulations because even land-use regulations cannot sustain prices (long-term) above a rational value.

But let's suppose I'm wrong and that all price increases were caused by a shift in demand in an inelastic market. The principle works in reverse, too: Slight shifts downward in demand cause steep drops in prices. Since there's no question that the collapse of the subprime markets caused a drop in demand, these inelastic markets had to see a steeper decline in prices than inelastic markets, at least if you accept basic principles of supply and demand.

Supply-and-demand does not tell you where the price increases decreases will be steepest within a metropolitan area, but the price declines ultimately must be blamed on supply inelasticity.

Related Links:

1. Bubbles (Dec. 7, 2008)

2. Bubbles again (Dec. 10, 2008)

3. The housing bubble as I see it (Dec. 16, 2008)

4. Glaeser and Gyourko on the housing bubble (Dec. 17, 2008)

5. Central city land-use regulations and the bubble (Dec. 17, 2008)

Visualizing the housing bubble

Here's a great flowchart from Mint.com (via neoHOUSTON) explaining the housing bubble.  I think it portrays the psychology of the housing bubble pretty accurately:  

I'd add a "Rapidly rising home prices" box to the first chart and an arrow pointing to "Mania for homeownership."

Central city land-use regulations and the bubble

I lied.  One more post on the housing bubble.

A couple of commenters here have suggested that tight land-use regulations in some central cities may have cushioned them against sharp price declines.  They point out that the more loosely zoned exurbs, rather than the central cities, have been hit hardest.

I don't know that the exurbs have in fact been hit hardest, particularly when one considers absolute price declines rather than relative declines.   The Case-Shiller index, unfortunately, does not distinguish between central cities and suburbs.

But even if it is true, so what?  Stringent land-use regulations, particularly anti-density regulations, push new development out to the exurbs.  Anti-density regulations in the suburbs, also an alleged hedge against the bubble, then push the exurbs farther and farther from the central city.  This makes the exurbs more vulnerable to price declines for at least three reasons.  First, a house 30 miles from a business center is less desirable than one only 15 miles away.  Second, a house 30 miles from central city amenities is less desirable than one 15 miles away.  And finally, homes in distant exurbs are more vulnerable to spikes in the price of gasoline.  It stands to reason that when the bubble burst, these homes would be the first to take the hit.

It's true these exurbs had looser zoning. But zoning restrictions become increasingly irrelevant as one pushes out to the limits of a metropolitan area. As demand for housing tapers off, land becomes less scarce relative to demand, and zoning restrictions no longer artificially constrain the supply.  I don't think that loose zoning in the exurbs bears the blame for the rapid price declines there.

Stringent zoning may have helped cushion central-city prices, but they imposed a steep, steep cost on the metropolitan area as a whole by making metropolitan-area prices more volatile.   Central cities can't dodge responsibility merely by arguing that their regulations made them better off.

Glaeser and Gyourko on the housing bubble

I don't think anyone bought my explanation of the housing bubble.  I'll make one last go of it.  This time I'll try an appeal to authority.  

Urban economists Ed Glaeser and Joseph Gyourko have just published a short e-book (pdf) entitled Rethinking Federal Housing.  The book is mostly about, well, federal housing policy, with an emphasis on policies for making housing more affordable in some of the nation's most expensive markets.  A good chunk of the book focuses on the culpability of some local governments for high home prices.  

While browsing the book last night, I was delighted to come across this passage,  which more or less matches the argument I've been running the last few days: 

While demand-side policies can increase the volatility of housing prices, policies that make supply more elastic can reduce that volatility. Housing prices are much more volatile in markets where supply is constrained by regulation (Glaeser, Gyourko, and Saiz 2008). In well-functioning markets,both price and quantity can adjust to changes in demand conditions. In supply-constrained markets, most of the adjustment occurs in the price of housing because stringent land-use regulations make it too costly to change the quantity of housing very much. The absence of supply adjustment makes these markets more volatile over time, both on the upside and downside of the cycle. Hence, housing supply restrictions, not just problems in the mortgage market, help account for the magnitude of the price movements that we see in the nation’s coastal markets especially.

Glaeser, Gyourko, and Saiz (2008) argue that price bubbles are more likely to form in highly regulated markets because a very tight, or inelastic, supply of homes is needed to support the increasingly large price increases that sustain a bubble whenever demand is rising. It is more difficult for home prices to become disconnected from their fundamental production costs in markets where plentiful supply is forthcoming whenever prices rise much above those costs. In fact, housing construction jumped during the housing boom of the early to middle 1980s in these more elastically supplied markets such as Atlanta, and prices remained quite close to production costs throughout the cycle. It was the level of construction activity, not prices, that varied most over the cycle in the freer, more unregulated markets. The more recent boom did see a few such markets (e.g., Orlando, Phoenix, Las Vegas) experience temporary price jumps, but the length of their booms still is much shorter than in the more tightly regulated, supply-constrained coastal markets. Between 1996 and 2006, average real house price growth was forty-seven percentage points greater in the more supply-constrained markets: 81 percent real appreciation in the constrained markets versus 34 percent in the less-constrained ones.

The recent boom was widespread, but it was also much larger in the more regulated coastal markets, which indicates that housing supply conditions, not just demand factors associated with incomes and mortgage markets, play an important role in accounting for the very nature of booms and busts in different areas of the country. This also suggests that sound policy to counter overly restrictive local regulation of new construction can have benefits beyond those directly associated with making housing more affordable.

(See pp. 2-3; emphasis mine).

I don't think any sensible person would argue that land-use regulations in the coastal markets alone caused the bubble.  But they played an important role.

The housing bubble as I see it

I got some push-back on my claim that tight zoning restrictions in some jurisdictions helped spark the housing bubble.  Below I set out some evidence to support my claim.

Let me first explain in a little more detail how I think the bubble developed:  

1.  In 2001 or thereabouts, tightly regulated markets like Miami and California experienced a bump in demand.  (Yes, the supply of housing in Miami is fairly inelastic, as I show below the jump.)

2.  Thanks to tight zoning restrictions, the housing prices in these markets spiked.  

3.  The bubble did not necessarily start with this spike in prices.  A surge in housing prices in a tightly-zoned market might be perfectly rational because rising demand also pushes up rents.

4.  Although the initial surge in prices might have been justified by market conditions, the rapid rise in prices triggered the bubble:  homes began trading well over their fundamental value, as measured by their rental value, as more and more investors entered the market to exploit the rapid rise in prices.

5.  The bubble could not have happened without the securitization of mortgages and lax lending standards; these allowed everyone and his dog to get into the game. 

6.  Bubbles by their nature are contagious.  The California bubble spread to the much more elastic markets of Phoenix and Las Vegas.  The bubble in Las Vegas lagged the California bubble by at least a year; the Phoenix bubble lagged California by at least two years.

7.  The bubble burst.  Naturally, the crash has been worse in places like Phoenix and Las Vegas where developers could quickly add housing.

Did the tight land-use regulations in California "cause" the bubble?  If I can mix my metaphors, I think tight land-use regulations were kindling.  The initial surge in demand was the spark.  And the monopoly money flooding the market acted like lighter fluid which banks kept squirting on the fire. 

Bubbles again

I did not mean to suggest in my post on bubbles that the Great Panic of 2008 could have happened without restrictive land-use regulations, exotic securities, lax lending practices or the other likely culprits.   I did mean to suggest that bubbles don't need bad regulation, sleazy lenders, or loose monetary policy.  They develop spontaneously even in simple financial markets where the participants have perfect information.

Although bubbles may be inevitable, they don't normally cause the collapse of the real estate industry and credit markets (and who knows what else).  I'm sure that 100 years from now economists will still be debating the causes of this bubble.

Too much leverage and bad risk models bear at least some of the blame.  But tight land-use regulations in California and the northeast played a role, too.  Economists Ed Glaeser and Joseph Gyourko demonstrated in this May 2006 paper that restrictive land-use controls are associated with more volatile home prices:

In today's still solid housing market, we may have forgotten the historical correlation between housing price growth in one period and decline over subsequent periods.  For example, Joseph Gyourko and I have found that if an area has a $10,000 dollar increase in housing prices during one period, relative to national and regional trends, that area will lose $3,300 in housing value over the next five-year period, again relative to national and regional trends (Glaeser and Gyourko, forthcoming).  Such housing cycles occur almost everywhere, but the dollars involved are far bigger in metropolitan areas with restricted housing supply such as many parts of California, New York, and Boston.  Illustratively, booms and busts in the Atlanta region have been relatively modest while in Boston, the last boom was followed by a 30 percent drop in housing values between 1988 and 1994.  Moreover, this boom-bust cycle was associated with significant dislocation in the regional economy.

It's not hard to figure out why home prices are more volatile in tightly-regulated jurisdictions.  When the supply of new housing is severely limited, even a small increase in demand will cause a spike in home prices.  This spike, when combined with the perception that prices will continue to rise, lures other buyers into the market who want a piece of the windfall, which causes a larger spike, and so on, until the Ponzi scheme comes crashing down.  Tight land-use regulations thus pull double duty:  They cause the initial spike by constraining supply and they reassure buyers that supply will be constrained in the future.  This is why the bubble started in places like California and Boston rather Houston or Dallas.

I admit this can't be the full story, though, because Phoenix and Las Vegas were eventually swallowed by the bubble even though it's easy to build new housing in both cities.   And this does not explain why lenders were so willing to extend credit to bad risks, or why investors were so willing to buy arcane financial instruments that they did not understand, or why sophisticated companies like AIG so grossly miscalculated the risk of default of the securities they insured.  

Hopefully we can figure these things out to avoid economy-crashing bubbles in the future.  Given the experimental evidence, though, we will have bubbles no matter what we do; the best we can hope for is to limit their size and the damage they cause. 

Bubbles

As our economy slides into the abyss, people are naturally trying to identify the culprit.  The root cause of the crisis, of course, was the real estate bubble and its enabler, the over-leveraged financial industry.  But what specifically triggered the bubble?   Was it Greenspan's lax monetary policy?  Banks' overly lax lending standards?  The feds' failure to regulate CMOs and CDS's and other exotic financial instruments?  Or can we pin the blame on some jurisdictions' overly restrictive zoning laws that allowed real estate prices to spike in the first place?  

Perhaps bubbles simply arise out of our brains' funny wiring.  According to this interesting piece by Virginia Postrel, experimental economists have concluded that they do:

For more than two decades, economists have been running versions of the same experiment. They take a bunch of volunteers, usually undergraduates but sometimes businesspeople or graduate students; divide them into experimental groups of roughly a dozen; give each person money and shares to trade with; and pay dividends of 24 cents at the end of each of 15 rounds, each lasting a few minutes. (Sometimes the 24 cents is a flat amount; more often there’s an equal chance of getting 0, 8, 28, or 60 cents, which averages out to 24 cents.) All participants are given the same information, but they can’t talk to one another and they interact only through their trading screens. Then the researchers watch what happens, repeating the same experiment with different small groups to get a larger picture.

The great thing about a laboratory experiment is that you can control the environment. Wall Street securities carry uncertainties—more, lately, than many people expected—but this experimental security is a sure thing. “The fundamental value is unambiguously defined,” says the economist Charles Noussair, a professor at Tilburg University, in the Netherlands, who has run many of these experiments. “It’s the expected value of the future dividend stream at any given time”: 15 times 24 cents, or $3.60 at the end of the first round; 14 times 24 cents, or $3.36 at the end of the second; $3.12 at the end of the third; and so on down to zero. Participants don’t even have to do the math. They can see the total expected dividends on their computer screens.

Here, finally, is a security with security—no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes. The problem doesn’t seem to be that participants are bored and fooling around. The difference between a good trading performance and a bad one is about $80 for a three-hour session, enough to motivate cash-strapped students to do their best. Besides, Noussair emphasizes, “you don’t just get random noise. You get bubbles and crashes.” Ninety percent of the time.

Bubbles, in other words, do not need an external cause other than our silly human instincts.

How to prevent bubbles is the $2 trillion question.  In the experiments, bubbles stopped forming once the participants had played the game a few times. The participants learned that a bubble was inevitable so they tried to get out of the market earlier; eventually, no one would pay more than the security's fundamental value for fear of getting stuck when the bubble popped.  But as soon as the rules and stakes were altered, the participants went back to creating bubbles.

The government could tax bubble profits.  That would kill Ponzi schemes before they started.  But how does the government identify a bubble?  It's easy to identify one when a security's fundamental value is a matter of simple arithmetic.  It's harder to identify one in the real world.  For example, last spring's stratospheric oil prices might have been the result of a bubble.  But perhaps they weren't.  Perhaps oil was just scarce and the high prices were needed to ration the limited supply.  I'm not sure how the government is supposed to tell the difference.